World View & Market Commentary. Forest first; Trees second. Focused on Real & Knowable facts that filter through the "experts" fluff and media hyperbole. Where we've been, what the future may hold and developing a better way forward.

Sunday, October 17, 2010

Nate here - Lately I’ve been talking again about the insolvency of the major banks and how their “assets” have been built largely upon fraud and Mark-to-Model (fantasy) accounting. It is absolutely Enron times a million. This is a Ponzi scheme because it requires ever increasing quantities of new cash to keep it going. It collapses when new cash can no longer service the fantasy that’s been created and passed off to investors. No cash flow, no fantasy.

But that doesn’t stop those who try to justify holding derivatives and mortgages at a model price that is based on default rates and prices of bubble years gone by. Obviously the bubble has burst, but these models are used to avoid taking losses. Losses are in fact so huge that should the banks be forced to mark their “assets” to their current value they would be quite literally unable to claim positive net worth. In fact cash flows have already completely collapsed, that is exactly what the crisis of 2008 was about. The interim “solution” has been to allow the banks to exchange those “assets” to the Fed in exchange for cash (cash backed by the people’s future earnings). Call it whatever you want, Quantitative Easing, Permanent Open Market Operation (POMO), whatever… it’s all the same, and its purpose is two fold: First is to create the illusion of cash flow so that the Ponzi doesn’t collapse, and the second is to artificially buy down interest rates.

But accounting fraud isn’t just a bank thing; it is rampant throughout corporate America. It’s Enron times a Billion.

Corporate “earnings” have become nothing short of a marketing event. “Expectations” are managed not by professional financiers, but instead by marketing professionals who are often promoted to the very top ranks of corporations – CEO’s, for example, now often have marketing expertise as it is more highly valued in this era of spin than is real operational expertise. Why shouldn’t it be? Corporations can set expectations as desired and always “beat” those expectations by using tricks such as reporting “operating earnings” that exclude “one time” events. Of course these one time events occur every single quarter. The financial media spins these expectations to investors who have bought off on the concept that it’s the “beat” that matters, not the actual performance. The industry further spins valuations basing them on some FORWARD looking model – in other words earnings models based upon the performance of financially engineered mark-to-fantasy models.

How much of an influence is this? The chart below is a chart from the “Federal” Reserve Bank of St. Louis illustrating total Corporate Profits After Tax. Note that profits went parabolic as derivatives and Mark-to-Model accounting exploded. Then in September, 2007 FASB (Financial Accounting Standards Board) instated rule 157 known as “fair value accounting,” or what is referred to as Mark-to-Market. Note what happened to corporate profits during this time! Then in 2009 under pressure from the banks, Congress, in turn, pressured the FASB to reinstate Mark-to Model accounting – and just look at corporate “profits” as a result!

Below you can see a chart of Corporate Profits After Tax compared to the S&P 500 price in red:

This same effect can be seen when looking at trailing price to earnings ratio, the only P/E ratio that matters and has been used consistently up until the modern era of spin. Note how Mark-to-Market accounting revealed the true valuation of the market! Then Mark-to-Fantasy is reinstated and the true value of the market is again hidden to obscure reality:

While I’m not an accountant, I have a lot of accounting experience and have had training in the field. What I also have is experience in the military, in my own businesses and investments, and also working in a large corporate environment. My military and corporate experiences opened my eyes to the way the world really works at this point in time. Let’s just say that I have moral and ethical problems with the way things are going. That’s why it’s nice to read a realistic personal report from someone who is an accounting professional and who also possesses a moral compass! Hopefully the next time you are reading a corporate annual report or are being bombarded with what a great value the market is, or how XYZ “beat” the street, you will understand that it is a professionally spun game that may not be entirely on the up and up…

I've lived though more than five decades thinking that people are basically decent but after all that has happened and the many facts that have come to light in recent years, I guess I'm pretty naive.

Indeed, a post by Charles Hugh Smith, author of Survival+: Structuring Prosperity for Yourself and the Nation and publisher of the Of Two Minds blog, entitled "The Rot Within: Our Culture of Financial Fraud and the Anger of the Honest," features commentary by an accountant with decades of experience in high-level global consulting firms and Fortune 50 U.S. corporations that suggests things have truly reached a low point.

"I belong to a large number of finance organizations and sometimes I even assist clients with hiring a finance person. Since I have a lot of experience with finance and accounting, when I am interviewing these people I know when I am getting a BS answer and unlike most BS recruiters I do not steer away from controversy since I am truly looking for the most qualified for my clients and not who is just most marketable to them. After I start drilling down you would be amazed (or maybe you wouldn’t) how many of these CFO’s and Controller types were basically dismissed because they would not cook the books in some manner.

Now maybe I have told you that I was asked to resign from one of the nations largest companies (a company that I worked hard for and saved from bankruptcy and due to my actions had created) in the US because I refused to book a revenue entry for over a million dollars which was unsupported and the CFO (I had been the CFO up until a merger) blew up with me when I asked him to send a memo telling me to record it. Funny, a few years and one acquisition later it melted down as one of the biggest accounting frauds in US history.

My next gig as the CFO for a NYSE company I basically walked in and found what I would consider a $60 million dollar accounting fraud in one day (once again a mark to market issue draining cash flow and sucking the company into a dark hole). Corrected that accounting problem and the company began to prosper but since I thought the board and upper management was so corrupt I left (Chairman of the Audit Committee was found guilty at another large company for back dating options).

The next public company where not only was I the CFO but prior to that a board member, I was basically asked to resign for BS reasons a couple of weeks later after I pointed out what the board was asking me to do was basically wire fraud and of course they backed off quickly and said they would get a legal opinion from our law firm (one of the top 10 in the US) to cover me. In the same meeting our outside legal counsel said he had a problem giving such an opinion and I pointed out that a legal opinion did not keep me from being both civil and criminally liable. It should be noted that this was another company that 2 years before I came in and took the reins as CFO/COO and pulled the company out of black hole of looming bankruptcy and made it profitable in the first time in its history since it went public and then refinanced the company. In summary a year after I left the company had burned through the money I raised and the Board sold the company for nothing.

There is lots of bitterness out there with the straight shooting finance people. Many of them find themselves unemployable. This stretches from banks, Private Equity, Investment Banking, through the large accounting firms (the average partner in the large accounting firms any more is a pathological liar) to senior finance people in organizations. Right before Enron and MCI blew-up, I actually had a BS HR person tell me I was not flexible enough. I wanted to tell this idiot that I knew where flexibility got me and it was an orange jumpsuit. Bankers and Companies only hire the weakest and most pliable senior finance executives they can find.

One other short story. A while back I was at a networking meeting with a large group of CFO and ex-CFO’s. I asked this group how many thought that most CEO’s wanted a weak CFO working for them. Approximately 70% of the attendees raised their hand! You have to remember that the only person who had steady access to the Board is the CFO.

The point, the middle class is becoming torn and frayed and there is real anger out there. The common belief is that only the liars and thieves are moving ahead in this country."

Michael J. Panzner is a 25-year veteran of the global stock, bond, and currency markets who has worked in New York and London for such leading companies as HSBC, Soros Funds, ABN Amro, Dresdner Bank, and J.P. Morgan Chase. He is the author of When Giants Fall: An Economic Roadmap for the End of the American Era, Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, and The New Laws of the Stock Market Jungle: An Insider’s Guide to Successful Investing in a Changing World. He has also been a columnist at TheStreet.com’s RealMoney paid-subscription service and a contributor to AOL’s BloggingStocks.com. Panzner has appeared on or been quoted by CNBC, Bloomberg, The Wall Street Journal, USA Today, Barron's, Reuters, CNN, MarketWatch, BusinessWeek Online, TheStreet.com, Slate, CFO.com, and other print, radio and television outlets. His articles have appeared in Buyside, Stocks, Futures & Options, Management Review, and Business Credit. He is a New York Institute of Finance faculty member specializing in Equities, Trading, Global Capital Markets and Technical Analysis and is a graduate of Columbia University. He regularly speaks to a diverse range of audiences, from small groups of individuals with little specialized knowledge about money matters to gatherings of the world’s top financial professionals, on a variety of economic, business, and investment-related themes.